Contingent Control Rights and Asset Substitution: The Design of Long-Term Debt
Posted: 18 Jun 1999
Date Written: March 1999
This paper investigates the design of long-term debt contracts when management has the ability to divert or manipulate the cash flows, and when it is prohibitively costly for a third party, such as a court, to verify or prove any managerial wrongdoing. We show that debt with maturity longer than the life of the firm's assets becomes sustainable, if investors are granted the right to dismiss management and take over the company as a going concern in the event of default. Interestingly, it is the threat of dismissal that induces management to comply with the contract but it is the investors' ability to take over the firm in default that makes this threat credible. Despite the strong similarity of the control rights and the maturity of debt and equity, investors will not be indifferent between the two securities. If a project can raise long-term debt it can also raise outside equity but the reverse is not true: there are projects that cannot issue debt but may still obtain outside equity financing. This is so because of the nature of the control rights. Since debtholders have contingent control rights, they cannot exercise control unless default has occurred. Hence, a manager planning to default may start milking the assets prior to the default. To alleviate this potential asset substitution by management, long-term debt contracts must offer substantially higher incentive payments to the entrepreneur-manager. Thus, a project aiming to secure longer-term debt financing must show evidence of higher profitability than one seeking equity financing.
JEL Classification: G31, G32
Suggested Citation: Suggested Citation